In 2007, Apple Inc announced the introduction of the iPhone in the United States. At thesame time, it announced that the exclusive carrier for the iPhone would be AT&T (thenCingular). One of the reasons cited was AT&T’s investment in enabling ‘visual voicemail’ (anew and potentially revolutionary way of accessing voicemails). That investment was specific tothe iPhone and required to enable the service. It had no value outside of the relationship betweenApple and AT&T – it was purely internal.The notion that exclusive contracts are utilized to encourage certain types of investment – particularly, specific ones – has been long-standing (Klein, 1988; Frasco, 1991). However, thisargument has been challenged by Segal and Whinston (2000). Their
showsthat in a market with one downstream buyer, one upstream seller, and one upstream potentialentrant, exclusive contracts have no effect on the level of relationship-specific (internal)investment.
In their model, firms’ payoffs are a function of their marginal contribution tofeasible coalitions. Segal and Whinston allow parties to exclusive contracts to renegotiate in theevent that both parties can be made better off if the contract is suspended and the downstreamfirm is allowed to trade with the incumbent. Exclusive contracts eliminate the payoff fromcoalitions which do not include the two parties to the contract, because the two parties cannotnegotiate to release each other from exclusivity. Investments, however, only raise the payoffs tocoalitions which
include both parties to the agreement, and so the increase in profits availableto investing parties is independent of whether exclusive contracts exist or not.Of course, the Apple/AT&T situation is one where there is competition both amongst phone manufacturers and mobile carriers. While the return to internal investment, in a marketwith a bottleneck firm in one segment, does not change when there can be renegotiation amongstthe contracted parties, the question is whether internal investment is similarly unaffected whenthere is an additional independent entity in the other segment. In an important generalization tothe Segal and Whinston environment, we demonstrate that the
continues tohold in a market with both downstream and upstream competition. Moreover, we demonstratethat exclusive contracts signed by one upstream/downstream pair do not effect the strongly
Internal investment between two firms is defined as investment that only affects the payoff from bilateral trade between the investing parties, and does not affect the payoff from bilateral trade between any other pairs..